Financial Regulation Summary
This summary will follow the same outline as the slides and the lectures. The headlines are
distributed by topics. These topics can also be found in the syllabus of the course. Normally I
summarize using the lectures, but here it would make more sense to just divide it into
topics.
The guest lectures of this course are also summarized, they will not be seen as a topic but
rather as a guest lecture. They can be found after the topics.
The student presentations are also summarized, they will be given their own topic. You can
find those after all the topics and guest lectures. These are not in chronological order but
instead in an order that made sense in my opinion (e.g. the “changes to the Dodd-Frank act”
presentation is after the presentation about the Dodd-Frank act itself).
Finally, the problem sets are discussed at the very end of the document, after the student
presentations.
,Topic 1 Introduction and Background and Regulation in
the Netherlands
Note: regulation in the Netherlands is actually part of topic 2, but it will be discussed here
since prof. Zeisberger ties it in to the background.
Why do we need financial regulation?
- stuff breaks
- people get unemployed
- crises
- example of the 2007 financial crisis
subprime mortgages hit mortgage companies, which hit lenders, hitting home builders,
hitting markets, then the US economy and finally the worldwide economy.
- you might want to repair this, using financial regulation.
- Markets usually work pretty well, but need to be regulated in the case of a market failure.
A market failure is a market that doesn’t deliver a pareto-efficient allocation of resources.
Pareto-efficient means it is not possible to improve one person’s lot without making
someone else worse off.
Figure 1: the Edgeworth box
figure 1 is called an Edgeworth box. It shows two utility curves, based on the players’
preferences. The two people (OA and OB) can exchange goods. This exchange is determined
on both player’s indifference curves. This exchange rate doesn’t have to be constant,
because the indifference curves don’t have a constant slope either.
The first theorem of welfare economics tells us that the free market will achieve a pareto-
efficient outcome, provided that there is perfect competition, full information and no
externalities. This assumption also makes mathematical models easier to write.
- perfect competition: there are lots of producers which keeps prices low.
- full information: everybody has access to all information in the market
- externalities: can be positive (e.g. knowledge spill-overs) or negative (pollution)
,However, this is not the case in practice all the time. This asks for regulation.
What is the rationale for financial regulation? Why should we regulate markets?
- protect against monopolies, because sometimes competition isn’t perfect
- consumer/investor protection, because sometimes information isn’t full/perfect
- systematic risk, because sometimes there are externalities
- efficiency of monitoring: larger companies/institutions are much more efficient at
monitoring/investigating than you on your own could ever be.
Protection against monopolies:
Most economic regulation is mainly concerned with preventing unwanted concentration of
market power. Most of the finance is pretty competitive, not so much a problem. A potential
issue here are the platform effects. It is often efficient to have a single central exchange /
clearing system / payment system. This is done via a platform. When a platform becomes
more useful, more people will use it. This results in a spiral towards a single platform that
gains. This is a degree of monopoly power. A solution to this is regulating as a utility.
Example of the Onion king: guy started trading in onion futures, decided to buy up all the
futures he could find. He ended up with 98% of the onion futures, making the price sky
rocket because of a shortage. He then started short-selling the futures, unleashing all his
onions until a bag of onions was worth less than the bag they came in. To this day, it is still
illegal in the US to trade in onion features.
might be an exam question about this.
Consumer protection
Many consumers of financial products lack information and understanding of financial
products information asymmetry.
Therefore, they need to be protected against themselves.
- banks/insurances/funds are able to screw the consumer
- banks/insurances/funds could collapse, rendering the consumer with nothing.
There is a difference between prudential and systemic regulation:
- prudential regulation (or micro-prudential) aims to maintain solvency of individual
institutions
- systemic regulation (or macro-prudential) aims to prevent contagion and widespread of
financial crises
Behaviour regulation/Conduct of business
- includes regulating information disclosure, competence, fair business practices, marketing
of products, honesty and integrity etc.
- if you go to the bank, the banks are forced to give you certain information. You are
provided with a KIID, a key investment information document. This states all legal
information you need to know when, for example, taking a mortgage.
- the regulatory tools that can be used are licensing (you need certain expertise’s that are
, linked to a license to do certain activities), fines, entry qualifications, ethics standards,
ombudsmen etc.
- it can also be self-regulated (industry regulates itself) or externally imposed (outsider
checks if everything is correct), like the international accounting standards or stock
exchanges.
We make a distinction between wholesale and retail investors.
- retail investors are everyday investors, the normal Joe’s.
- They are likely to be less knowledgeable or experienced because they have a lack of
repeat interactions/experience
- They have a higher cost of acquiring information
- They have limited ability or time to acquire the necessary skills.
- They are even worse at evaluating the soundness of an institution as a whole.
- They may not be able to monitor long-term contracts
- They are unlikely to have any influence on a company.
- institutional investors are bigger groups like pension funds and sovereign wealth funds,
that make their profit by large-scale trading in investments. They are often in a better
position to evaluate an offer than the average investor.
What are the reasons for prudential regulation, even in the absence of systemic concerns?
Why would we control risks of companies and why not just let bad companies fail? Market
can regulate itself, right? (neoclassical approach).
First off, there is asymmetric information. It is difficult for consumers to judge solvency of
financial institutions, so market is unlikely to function like it should.
Second, there is moral hazard. People start behaving differently after they have signed a
contract. This causes very large potential losses. There is a potential claim on compensation
or deposit insurance fund.
Besides these prudential/consumer protection rationales for regulation, we also have
systematic rationales for regulation:
- whenever there are large externalities of a failure of a financial institution and those
externalities are not included in the decision-making of financial institutions, there is a case
to be made for additional regulation.
- Banks are especially in need of regulation:
- they are inherently unstable at any time you can take all your money back
- they are inherently contagious, meaning if one falls they all go down |
- banks are the main and only source for borrowing money
- disrupt the payment system if they were to fall
- when other financial institutions fail, they are much less likely to cause contagion. They
also don’t disrupt the payment system, and there is often no perceived lender of last resorts.
Finally, they usually hold liquid assets that can be sold of easily. Therefore, it is less of a
problem when any other financial institution falls.
